An extremist, not a fanatic

September 12, 2011

The Vickers threat

Urban legend has it that when a plane is about to crash, passengers are asked to adopt the brace position not because this will save their lives, but because doing so will protect their teeth and so make it easier to identify the corpses from dental records.I was reminded of this by the Vickers’ report recommendation that retail banking be ring-fenced from investment banking. The purpose of this, as Jonathan says, is not to reduce the risk of failure. It is instead to assist the clean-up operation after failure - to make it “easier and less costly to resolve banks that get into trouble” because such relatively simple operations are easier to either unwind or sell on than investment banks with their countless counterparties and opaque assets.Instead, Vickers’ plan to reduce - not, note, eliminate - the risk of banking failure lies in the call for higher capital ratios. In themselves, these aren’t the problem; the 10% he recommends is actually slightly lower than banks have now (though any losses from the euro area debt crisis and associated economic slowdown will reduce these). There are, though, two other problems:1. Vickers calls for a further 7-10% of banks’ assets to consist of “loss absorbing” liabilities such as bail-in bonds, cocos or unsecured debt.However, given the riskiness of banks’ activities, investors will only want to hold these on Buffett-style usurious terms. This will raise banks’ costs.2. Vickers threatens the basic model of investment banking. A lot of its activities are low-margin near-arbitrage trading - hoovering up pennies. To make this profitable, you need lots of hoovers - high leverage. Which Vickers opposes.For example, last year Barclays Capital made £4.8bn profits on £191.3bn of risk-weighted assets (p46 of this pdf), a return of 2.5%. But this was in a very favourable time - near-zero borrowing costs. In 2006-07, return on RWA was just half this (p59 of this pdf). This means that if Barcap must hold 10% of its assets in equity, return on equity would be around 13% in normal times. This is in line with Bob Diamond’s target - but it shows how hard it will be to much exceed that.In these two ways, the Vickers report is a threat to the banks.But this is not a bug. It’s a feature. A major purpose of the report is to remove the implicit subsidy which governments give to banks both by offering to bail them out if they get into trouble, and by giving tax relief on debt. Vickers says:

The risks inevitably associated with banking have to sit somewhere, and it should not be with taxpayers

Although Vickers estimates these subsidies to be more than £10bn a year, he estimates that his proposals will cost banks less than this: £4-7bn. In this sense, Philip Aldrick is right. Banks got off lightly. Which brings us to questions raised, but not answered, by the report:1. How much would banks be worth if the implicit subsidy did not exist? Last year, the combined profits of Barclays, Lloyds and RBS were just £10.2bn, suggesting that banks might be almost worthless without that implicit state aid. And this raises the question; if banks were of nugatory value, how on earth could they raise sufficient capital from the private sector to provide the loss absorption which Vickers wants? There is a trade-off between reducing the tax-payers' exposure and increasing banks' loss-absorbers.2. How much do the Tories really believe in the Thatcherite virtues of self-reliance and standing on your own two feet? If they did, their only quibble with Vickers would be that he doesn’t quite go far enough. Which doesn't seem to be the case.

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"suggesting that banks might be almost worthless without that implicit state aid. "

you can't really make counter factual claims like that. I suspect if implicit state aid was removed, the banking industry would find a way of being profitable, it would just have to change what it does at what prices

how on earth could they raise sufficient capital from the private sector to provide the loss absorption which Vickers wants? ....

isn't the (text book) answer to that ex-post once banks are well capitalized, the risk of insolvency is low, an implicit state subsidy is not needed etc. cost of borrowing should be low by virtue of those big safe capital cushions ... or am I getting muddled up. This is sort of thing I'm thinking of:

@Luis Enrique, that's almost a truism. The question is, what would it do, and at what prices? Would there still be prop traders taking insane risks to make a few points? Or would all banks become something like hedge funds? The implicit state aid comes with a price of great regulation, so I suspect that to see what banking would be like without the implicit state aid, look at current players who have chosen to be outside regulation: hedge funds, own-account traders etc.

@Luis - one way in which a business becomes profitable without state aid is that it shrinks, so that less efficient providers exit and competition diminishes (thus allowing higher profits).
And well-capitalized banks are at little risk of insolvency only because it is shareholders who lose money first.
Faced with these two threats, shareholders will only buy new stock if expected returns are large enough to compensate. Which means bansk face a higher cost of capital.

Worth noting also (as Lydia Prieg from NEF does in the Guardian) that the absolute size of the banks, relative to GDP should be a big concern.

That's a critical factor in future crises. The countries hit hardest have been those who have had to put multiples of GDP into bailouts (e.g. apparently the UK put 101% of GDP into a bailout, Iceland is the extreme example however, I'd guess.)

"Usury centralises money wealth. It does not alter the mode of production, but attaches itself to it as a parasite and makes it miserable. It sucks its blood, kills its nerve, and compels reproduction to proceed under even more disheartening conditions. Usurers capital does not confront the labourer as industrial capital but impoverishes this mode of production, paralyzes the productive forces instead of developing them".

Yes but if that was all there was to it, higher capital customs means higher cost of capital full stop. However, point of arguments such as those I link to from FT suggest total cost of capital does not rise because non-equity cost of capital falls. Or something like that. Anyway, I know plenty of economists think higher capital requirements will not mean big increases is costs of capital.

Stephen, yes, fine. My point was merely you cannot say that without the implicit state guarantee banks would be unprofitable, that's just not true.

«My point was merely you cannot say that without the implicit state guarantee banks would be unprofitable, that's just not true.»

Actually your argument is that without free capital from the state current banks as we know them would cease to exist (as Lehman and Bear Sterns did, and a lot of others would have), and fundamentally different organisations based on a different business model but still perhaps called "banks" would come into being. That's a fair argument, but once laid out in full it feels rather different.

Because capital and its cost and business models based on it are very much central to the banks we know today, and any vast change in its cycle would really have profound consequences.

Both on individual banks and the shape of the industry.

Otherwise your argument is the banality that however deep the changes to the cost and source of capital "banking" as an activity would not disappear entirely, even if done by different entities in an industry working quite differently from now.

�And this raises the question; if banks were of nugatory value, how on earth could they raise sufficient capital from the private sector to provide the loss absorption which Vickers wants? There is a trade-off between reducing the tax-payers' exposure and increasing banks' loss-absorbers.�

It is much worse than that, as Taleb has pointed out that arithmetically over the cycle many if not most large banks generate negative profits, as all the profits made in the "good" years are smaller than the losses made in the "bad" years.

Indeed the negative difference is sometimes so massive that ban k capital is wiped out and bank require periodic massive infusions of state capital, a large part of which (probably around 50%) is then privatized in the "good" years of the cycle as bonuses and salaries for top employees.

Also note that banks get more than free capital from the state; they also get massive profitability subsidies via artificially low interest rates they pay the central banks, and artificially high spreads. This is well documented for the USA (but it happens in the UK too):

http://www.interfluidity.com/posts/1160447599.shtml
�the spread between the Federal funds (and Treasury bill) rate and the prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan's gift to the banking sector to insure that major banks would not fail.�

It became instead for at least 50% a massive gift to banking sector top employees.

�2. How much do the Tories really believe in the Thatcherite virtues of self-reliance and standing on your own two feet?�

It looks like that it depends on whether you are an exploitative loser like a wage parasite or a deserving winner like a bonus producer.

To some extent both parties believe in the virtues of a big state with high taxation and high spending, but on very different constituencies. Both parties are for social justice and prosperity, rewarding production and punishing exploitation.

It just happens that tories reckon that the craven poor exploit the deserving rich, and social justice means protecting and rewarding the rich with high spending on police, prisons and defence, and with free capital for highly productive national champions of finance. It is a moral issue...

«Surely the question should be what part of banking is economically useful. (from a Greater Good point of view, not a pure profit point of view). That is the job of government.»

Ahhh but that may work in a very different way from what you think.

One of the big issues of the past 30-40 years has been a massive situation of growing underemployment, which has been a major concern of all governments in the first world. This probably had several causes, but they include the flooding of the global jobs market by baby boomers, women (a very big story), by Japanese workers, by the reserve armies of labour in the East Asia tigers first and then by the BRIC.

Sure, if two people working instead of one output may well increase, but odds are it will not increase by two, but rather less because availability of capital, commodities, energy does not increase linearly with the number of workers (at least in the short term, and most likely in the long term too).

More or less all western governments have tried to conceal the problem, by several means, among them redefining what "unemployed" means in ever narrower terms, by pushing ever more people into university (and in prison in the USA) also as this induces more jobs.

One of these means has been to encourage the creation a whole lot of make-believe jobs, jobs that produce activity rather than value added, in order to absorb the extra supply of workers. An example would be I manage your pension account and you manage my pension account.

First world government have therefore been exceptionally keen to encourage the creation of economically useless jobs, because underemployment is better than unemployment, as people hate welfare scroungers while they greatly respect people who "produce value" by selling pension funds or trading derivatives or writing mortgage contracts. They have been particularly keen to create economically useless jobs to absorb the vast surge of demand for desk jobs by females, especially female graduates, but also export-oriented jobs.

Part of the push towards privatising very efficient government run programs like pensions etc., which can have very low overheads because of scale, has been the desire to create job opportunities for more economically useless middlemen, by reducing efficiency and increasing churn.

The finance sector jobs should have massively shrunk because of ever increasing efficiency in electronic fund processing (and Volcker sarcastically notes that the latest economically useful finance innovation has been the ATM), but it has actually increased both in size and especially in pay. At least it has the almost unique advantage that it does generate some export revenue and lots of tax revenue.

The UK government in particular has been very keen to encourage economically useless finance jobs, even at retail level outside London, in particular when the government is conservative, which may be unrelated to conservative association chairmen being often insurance salesmen, mortgage brokers, conveying solicitors, estate agents, ...

There are many interesting stories in the shifts in employment in the past few decades, and I have produced from this spreadsheet:

Among the interesting stories note that many of the jobs in professional, administration and probably also distribution are related to finance, and that essentially all job growth has been in "staff", non-export, sectors and essentially all job destruction in "line", exportable, sectors.

Thanks for the interesting discussion guys! But at this point in the AM I am not sure I follow all the intricacies. So much for insomnia, but I think it is true that Banking is always on the verge of collapse.So no precautions can avoid the danger of failure. State support express or implied does not change that reality. The key idea I wish to propergate is that the UK is like a third world country ( or LDC as Sir Humphrey Appleby would put it ). We are too dependent on one industry, namely Banking. Britain has become like Saudi Arabia or Chile. It may be that civil servants or M.P.s think it is wonderful to have a massive banking industry as it produces private sector jobs and tax revenue, but a massive Banking sector with large exposure to loss in foreign operations is a hostage to fortune. How can you rescue a Banking sector that is bigger or as big as all your GDP? Iceland could not. The real answer to this problem is for the uk to make and sell things other than financial services. To put all your eggs in one economic basket is a folly. The left and the right in politics both need to accept that unquestioning support for one sector over others is a mistake. They both seem unable to draw the logical conclusion from the world financial crisis that finance is too big and powerful yet equally fragile; like a top boxer with a weak "chin", invincible until the right blow is landed and then the boxer falls over. Do we want the whole Nation to fall as well? If not we need to reduce our dependency on the boxer.

If removal of the implicit state subsidy DOES drastically reduce the size of the banking industry, what of it? UK bank assets relative to GDP forty years ago were ONE TENTH of what they are now. Economic growth was little different then as compared to now.

Instead, Vickers’ plan to reduce - not, note, eliminate - the risk of banking failure lies in the call for higher capital ratios. In themselves, these aren’t the problem; the 10% he recommends is actually slightly lower than banks have now (though any losses from the euro area debt crisis and associated economic slowdown will reduce these).

«If removal of the implicit state subsidy DOES drastically reduce the size of the banking industry, what of it?»

Loss of a lot of economically useless jobs, and in sectors that traditionally employ tory or "aspirational labor" voters. Not good for politics.

«UK bank assets relative to GDP forty years ago were ONE TENTH of what they are now. Economic growth was little different then as compared to now.»

That's a bit of a different talk, because it is mostly about what one clever blogger calls the elasticity of GNP to debt, treating debt as a kind of factor of production. The idea is that at relatively low levels of debt, expanding credit by 1 pound may well increase GNP by nearly 1 pound, but as debt levels increase, a 1 pound of extra credit generates much less in GNP increase, and that eventually goes into negative territory, and you realize that you have been living in Argentina or Greece.

But consider this: given that GNP's largest component is consumption, how would GNP growth have been if the banking sector had been much smaller, and therefore similarly would have been the professional and administration sectors, and lots of economically useless jobs had not existed while manufacturing jobs collapsed?

Sure, lots of people consuming with economically useless jobs keeps the GNP up, but also debt levels go up (because people who consume while not producing value added must result at some point in capital drawdown).

To a large extent the existence of so many economically useless jobs has been masked by North Sea oil revenues, and their effect on exports and tax take, but that is coming to an end, and this is by far the most important graph (already mentioned) to understand the UK's economic past and future:

«but I think it is true that Banking is always on the verge of collapse.So no precautions can avoid the danger of failure.»

That is by design, to maximize the income of agents in the banking job market. These guys are all sharp arbitrageurs, and surely they have long ago factored in the implicit value of the supply of free capital by the government, and they trade on that.

And they keep that supply coming in by holding hostage the payment system and the trade payment system. Thus the separation proposal in the Vickers report.

The critical moment in the current crisis was when banks started to refuse to accept bills of exchange, a little noticed detail, which would have meant empty Tesco shelves and no fuel for transport or heating. That's even worse than ATMs being switched off and bank runs.

Bankers today are the equivalent of miners in 1980: they try to hold the political class and the rest of the country at ransom by holding as hostage a critical function of the economy.

In the 1980s the miners were vanquished by the surge in North Sea oil supplies and the determination of the political class to use that to find the space to secure alternatives to the local coal supply. The Vickers report may be the contemporary equivalent to that, the answer to "who governs the country? The parties or the banks?"

What's the net cost of the UK banking bailout? Alistair Darling's last budget report put it at £6bn. (It changes with the value of the UK government's shareholdings, so it will have gone up since then.)

What's the UK's tax take from the City of London? Darling's bonus tax alone raised £3.46bn according to HMRC. Add in income tax, national insurance, and VAT on the money bankers spend, and the annual tax take from the City is of the same order as the net cost of the bailout.

From the point of view of the UK, banking is profitable, if only because most of the banks operating in London are not British, so the UK doesn't have to pay for any bailouts they may need.

«What's the net cost of the UK banking bailout? Alistair Darling's last budget report put it at £6bn. (It changes with the value of the UK government's shareholdings, so it will have gone up since then.)»

That sounds to me like a specious and malevolent argument, because the cost of that bailout is the sum of years of recessions and crazy government policies like zero percent interest rates to the banks that have been its consequences.

Baking shares are up only because the government has been desperately creating a bank share bubble by making banks artificially profitable with zero-cost blanket guarantees, zero percent lending, and non-zero percent borrowing, and screwing up the rest of the economy in order to do that.

Then there is the previous cost of the banking sector: many years of artificial bubbles in asset prices to support "national champion" speculation oriented banks, the increasing financialization of the economy that has displaced productive investment.

What goes in the government accounts is just the tip of the iceberg and it is carefully "managed" to make it look good.

«From the point of view of the UK, banking is profitable, if only because most of the banks operating in London are not British, so the UK doesn't have to pay for any bailouts they may need.»

This is a very clever observation: foreign banks spend their foreign government provided capital in London on bonuses and salaries, and in bad business, but then the foreign governments are liable for that.

Why then does the UK treasury need to bail out UK banks? Why does the UK need them, if it can take the benefits but not the liabilities by acting as a host to foreign banks?

That would have been a very good reason to let Northern Rock, RBS, etc. fail or be sold to some gullible foreign government for a pound.

There are legacy reasons, mostly related to pensions and insurance funds: in the recent crisis who has been bailed out is really not the banks, but their creditors, and foreign governments might want to bailout their national banks but let their foreign creditors go under.

But the solution to that is to regulate UK pension and insurance funds so that they aren't creditors of blowup-prone foreign banks.

Ahhh but we got back to asset bubbles again: pensions and insurance funds have become creditors of very dubious debtors to chase yield, and they have to chase yield because they have challenging nominal returns targets, and nominal interest rates are too low in order to create asset bubbles to please retail house owners and create an environment for banks to make big capital gains too. And we are back...

Then there is the previous cost of the banking sector: many years of artificial bubbles in asset prices to support "national champion" speculation oriented banks, the increasing financialization of the economy that has displaced productive investment.